SCHD Will Never Be the Same After This
Summary
Brian explains that the highly popular SCHD ETF, which manages nearly $100 billion, recently underwent a significant reconstitution, removing 22 stocks and replacing them with 25 new ones. He highlights that the removed stocks were up an average of 6.7% this year, while the newly added stocks were down an average of 9.4%, representing a 16 percentage point swing. This counterintuitive move is not due to company failures or dividend issues but an inherent part of SCHD's rules-based investment strategy.
SCHD tracks the Dow Jones US Dividend 100 Index, which has no human portfolio manager. Annually, the index re-evaluates its holdings based on a strict formula. To qualify, a company must have paid dividends for at least 10 consecutive years. Companies are then scored on four metrics: return on equity, cash flow relative to debt, current dividend yield, and five-year dividend growth rate. Only the top 100 companies make the cut.
Brian illustrates this with the example of energy stocks. Last year, SCHD significantly increased its energy exposure, which paid off as the sector surged. However, due to their strong performance, energy stock prices rose, which, in turn, *lowered* their dividend yields (as dividend payout is a set dollar amount). This reduced their quality scores, leading to their removal despite being "winners." Brian clarifies that this isn't panic selling but the system working as designed.
Brian illustrates this with specific stock examples affected by the fund's methodology:
Brian addresses two distinct audiences:
Mentioned Stocks
Reasoning: Chevron remains one of SCHD's top five holdings. Brian highlights this to show that SCHD maintained its highest-quality energy sector exposures rather than completely divesting from the sector.
Reasoning: United Health was one of the largest additions to SCHD by market cap despite being down over 17% this year. Brian implies it was added because it scored higher on the fund's quality metrics, demonstrating that the fund prioritizes fundamental quality over recent poor stock performance.
Reasoning: Brian explains that SCHD recently underwent a significant reconstitution, removing 22 stocks and adding 25, including energy stocks that performed exceptionally well but saw their dividend yields decrease, thus lowering their quality scores according to the fund's rules-based methodology. For existing investors, Brian views this reconstitution as the fund's disciplined system working as designed, adapting to market conditions and positioning for long-term total returns. He highlights SCHD's impressive 232% return over the last decade with reinvested dividends, demonstrating its compounding power, which bonds cannot offer. Therefore, he advises existing holders that the fund's discipline will serve them well long-term. However, for potential new investors, he notes that the 10-year Treasury yield of 4.39% currently offers a higher risk-free return compared to SCHD's 3.5% yield, making treasuries more attractive for new capital deployment in the short term given current economic conditions and projected slow Fed rate cuts.
Reasoning: Valero was removed from SCHD despite being up over 45% this year. Brian explains that its strong stock performance led to a decrease in its dividend yield, which negatively impacted its quality score according to SCHD's rules-based index methodology, thus leading to its automatic removal from the fund during reconstitution.
Reasoning: ConocoPhillips remains one of SCHD's top five holdings even after the recent reconstitution. Brian mentions this as an example that the fund did not abandon energy entirely but retained "highest quality" energy names whose scores remained strong.
Reasoning: Devon Energy was newly added to SCHD's portfolio during the reconstitution and is up over 27% this year. Brian uses this as further evidence that the fund retained or added quality energy names that met its scoring criteria, even while shedding others.